FMP Lecture - Working Capital
FMP Lecture - Working Capital
FMP Lecture - Working Capital
• Sales impact
• Liquidity
• Relations with stakeholders
– suppliers
– customers
• Short-term financing mix
– profitability
– risk considerations
Working Capital Management
• Maturity matching approach
• Conservative approach
• Aggressive approach
Maturity Matching Approach
• Hedge risk by matching the maturities of
assets and liabilities.
• Permanent current assets are financed with
long-term financing, while temporary current
assets are financed with short-term financing.
• There are no excess funds.
Maturity Matching Approach
e nt A ssets
e nt Curr
Perman
Long Term
Financing
Fixed Assets
Time
Conservative Approach
• Long-term funds are used to finance both
permanent as well as some temporary short-
term assets.
• When there are excess funds, they are
invested in marketable securities.
Conservative Approach
nt A s sets
ne nt Curre
a
Permsecurities
Marketable
Long Term
Financing
Fixed Assets
Time
Aggressive Approach
• Use less long-term and more short-term
financing than the conservative approach.
Aggressive Approach
re nt Assets
ne nt Cur
Perma
Long Term
Fixed Assets Financing
Time
Cost and Risk Considerations
• Yield curve is usually upward sloping.
• Short-term rates are more volatile than long-
term rates.
• Firm's ability to obtain needed short-term
financing.
Cash Conversion Cycle
Time
Payables Cash Conversion Cycle
Deferral Period
Payment of
Accts. Payable
Cash Conversion Cycle
Receivable s
Receivable s 365
collection
Sales/365 Receivable s turnover
period
Payables Deferral Period
• The payables deferral period is the average length
of time between the purchase of materials and
labor and the payment of cash for the same.
𝐴𝑐𝑐𝑜𝑢𝑛𝑡 𝑃𝑎𝑦𝑎𝑏𝑙𝑒𝑠
𝑃𝑎𝑦𝑎𝑏𝑙𝑒𝑠 𝐷𝑒𝑓𝑒𝑟𝑟𝑎𝑙 𝑃𝑒𝑟𝑖𝑜𝑑=
𝐶𝑜𝑠𝑡 𝑜𝑓 𝐺𝑜𝑜𝑑 𝑆𝑜𝑙𝑑/365
Cash Conversion Cycle
Given the following information about Vision Opticals,
compute the firm’s cash conversion cycle.
Inventory $19,000
Accounts Receivable $21,000
Accounts Payable $5,600
Wages, Benefits, Payroll Taxes $9,000
Sales $227,000
Cost of Sales $93,000
Selling & Other Expenses $22,000
Inventory Conversion Period
Inventory
Inventory 365
conversion
Cost of Sales/365 Inventory turnover
period
Inventory
$19,000
conversion 74.57 days
$93,000/365
period
Receivables Collection Period
Receivable s
Receivable s 365
collection
Sales/365 Receivable s turnover
period
Receivable s
$21,000
collection 33.77 days
$227,000/3 65
period
Payables Deferral Period
Payables
deferral
period
Accounts payable Wages, benefits, payroll taxes payable
(Cost of sales Selling, general and administrative expenses)/365
$5,600 $9,000
46.34 days
($93,000 $22,000) / 365
Cash Conversion Cycle
Cash
conversion 74.57 days 33.77 days 46.34 days
cycle
62 days
Another illustration
• We can illustrate the process with data from Real Time Computer Corporation (RTC), which
in early 2001 introduced a new minicomputer that can perform one billion instructions per
second and that will sell for $250,000. RTC expects to sell 40 computers in its first year of
production. The effects of this new production RTC’s working capital position were
analyzed in terms of the following
• five steps:
1. RTC will order and then receive the materials it needs to produce the 40 computers it expects to sell.
Because RTC and most other firms purchase materials on credit, this transaction will create an
account payable. However, the purchase will have no immediate cash flow effect.
2. Labor will be used to convert the materials into finished computers. However, wages will not be fully
paid at the time the work is done, so, like accounts payable, accrued wages will also build up.
3. The finished computers will be sold, but on credit. Therefore, sales will create receivables, not
immediate cash inflows.
4. At some point before cash comes in, RTC must pay off its accounts payable and accrued wages. This
outflow must be financed.
5. The cycle will be completed when RTC’s receivables have been collected. At that time, the company
can pay off the credit that was used to finance production, and it can then repeat the cycle.
CCC Example - RTC
1. Selling price 250,000
2. Cost = 197,250
3. Annual Sales = $ 10 million
4. Average inventory $ 2 million
5. Receivables = $ 657,534
6. 1 month credit from suppliers
7. 1 month to pay labor
8. CGS = $ 8 million
9. Payables = $ 657,534
10.Calculate CCC
Inventory conversion period
• Inventory conversion period, which is the average time required to
convert materials into finished goods and then to sell those goods. Note
that the inventory conversion period is calculated by dividing inventory by
sales per day. For example, if average inventories are $2 million and sales
are $10 million, then the inventory conversion period is 73 days
Thus, it takes 24 days after a sale to convert the receivables into cash.
Payables deferral period
• Payables deferral period, which is the average length of time between the
purchase of materials and labor and the payment of cash for them. For
example, if the firm on average has 30 days to pay for labor and materials,
if its cost of goods sold are $8 million per year, and if its accounts payable
average $657,534, then its payables deferral period can be calculated as
follows:
• The calculated figure is consistent with the stated 30-day payment period.
Cash conversion cycle
• Cash conversion cycle, which nets out the three periods, therefore equals the
length of time between the firm’s actual cash expenditures to pay for productive
resources (materials and labor) and its own cash receipts from the sale of
products (that is, the length of time between paying for labor and materials and
collecting on receivables). The cash conversion cycle thus equals the average
length of time a dollar is tied up in current assets.
• Given these data, RTC knows when it starts producing a computer that it will have
to finance the manufacturing costs for a 67-day period. The firm’s goal should be
to shorten its cash conversion cycle as much as possible without hurting
operations. This would improve profits, because the longer the cash conversion
cycle, the greater the need for external financing, and that financing has a cost.
Desirable if:
1. Don’t increase cost
2. Doesn’t decrease sales
BENEFITS
• The benefits of shortening the cash conversion cycle by looking again at
Real Time Computer Corporation.
• Suppose RTC must spend approximately $197,250 on materials and labor to
produce one computer, and it takes about nine (9) days to produce a
computer.
• It must invest $197,250/9 = $21,917 for each day’s production.
• This investment must be financed for 67 days—the length of the cash
conversion cycle—so the company’s working capital financing needs will be
67 * $21,917 = $1,468,439
• If RTC could reduce the cash conversion cycle to 57 days, say, by deferring
payment of its accounts payable an additional 10 days, or by speeding up
either the production process or the collection of its receivables, it could
reduce its working capital financing requirements by $219,170.